15-year amortization for covenant not to compete in redemption acquisition.

Corp. sells and services new and used vehicles. R Corp. purchases and operates automobile dealerships and provides consulting services to those dealerships. S is R's president and participated in Y's management from 1987-1994. R purchased all of Y's stock in 1987. Y hired M, one of S's long-term employes, to be its executive manager. From 1987-1994, R allowed M to purchase 25% of Y's stock. By Aug. 1, 1994, R owned 75% and M owned 25% of Y's stock.

Y redeemed its stock owned by R under a stock sale agreement effective on Aug. 1, 1994. Because of the redemption, M became Y's sole shareholder. R, S and Y also entered into a noncompetition agreement ("covenant"), also effective on Aug. 1, 1994. It stated that R and S would not compete with Y for five years. Y agreed to pay R and S $22,000 per month for five years as consideration for the covenant. Y used funds borrowed from GMAC. Without the covenant, Y may not have been able to raise capital or pay its GMAC loan.

Y claimed that the covenant should be amortized for five years, over the life of the agreement, and not under the Sec. 197 15-year amortization period. The only issue is whether Y must amortize the covenant under Sec. 197.

Analysis

Sec. 197(d)(1)(E) provides that a Sec. 197 intangible includes "... any covenant not to compete entered into in connection with an acquisition (directly or indirectly) of an interest in a trade or business or substantial portion thereof." As a matter of first impression, the Tax Court held that the covenant was a Sec. 197 intangible, because Y entered into it in connection with the indirect acquisition of a trade or business. The Tax Court applied the plain meaning of Sec. 197, using dictionary definitions of "acquisition" and "redemption" and concluded that Y's redemption was an acquisition under Sec. 197, because Y regained possession and control over 75% of its stock.

Y argues that it did not acquire an interest in a trade or business in the redemption, because, both before and after the redemption, it was engaged in the same trade or business and acquired no new assets.

There are three problems with Y's arguments. First, Y's argument reads a. requirement into Sec. 197 that taxpayers must acquire an interest in a new trade or business. Sec. 197, however, only requires taxpayers to acquire an interest in a trade or business. Although Y continued its same business, acquired no new assets and redeemed its own stock, it acquired an interest in a trade or business, because it acquired possession and control over 75% of its own stock. In addition, the transaction's effect was to transfer ownership of the company from one shareholder to another (M, who previously owned only 25% of the shares, became the sole shareholder).

Second, Sec. 197's legislative history clarifies that "an interest in a trade or business includes not only the assets of a trade or business, but also stock in a corporation engaged in a trade or business." Here, Y acquired stock of a corporation that sells new and used vehicles; the result does not change merely because the stock acquisition is a redemption. Indeed, the transaction's substance was to effect a change of controlling stock ownership.

Finally, before enactment of Sec. 197, taxpayers could amortize covenants not to compete over the life of the agreement, under Regs. Sec. 1.167(a)-3. Congress passed Sec. 197 to simplify amortization of intangibles by grouping certain intangibles and providing one amortization period. This indicates that Sec. 197 treats stock acquisitions and redemptions similarly.

Because Y entered into the covenant in connection with the redemption of 75% of its stock, the covenant was a Sec. 197 intangible and Y has to amortize it over 15 years under Sec. 197.

FRONTIER CHEVROLET CO., 9TH CIR., 5/28/03

REFLECTIONS: Sec. 197's legislative history states that a stock acquisition is an indirect acquisition of an interest in a trade or business. Also, Regs. Sec. 1.197-2(b)(9) specifically provides that taxpayers can make an acquisition under Sec. 197 in the form or a redemption. However, the court did not apply it above, because it is generally effective for property acquired after Jan. 25, 2000 (i.e., after the transaction at issue).